Numerous foreign investments in the developing world were nationalised in the 1960s and 1970s. Mining and infrastructure projects were especially hard hit.

Louis T Wells and Rafiq Ahmed’s recent book, Making Foreign Investment Safe: Property Rights and National Sovereignty, begins with the story of one such investment, by ITT in the link between Indonesia’s telephones and the international satellite system. The 1967 project earned handsome returns for ITT until 1980, when it was nationalised by the Indonesian government. Indonesians had reacted strongly when ITT refused to make a politically desirable – but privately unprofitable – investment; in the ensuing investigations, Indonesians discovered that they could run the company perfectly well without the foreign investor and began to chafe under what they began to see as huge returns to the investor under the unregulated monopoly that had been granted. The company, once in a strong bargaining position because of its special know-how, was then in a much weaker position and succumbed to demands that it sell out. Thus ended ITT’s profitable subsidiary.

International moves

In the book, the authors write: “[In the 1980s] the world community tried to construct a new system that would end unilateral revisions of [host] countries’ commitments to foreign investors and nationalisation of their projects. The assurances included a greatly expanded role for arbitration of disputes, broader coverage under official political risk insurance, and more home government support for investors.

“The new international protections for foreign investment are quite unlike the rules of the World Trade Organization that govern international trade. The system for investment is not the result of a broad multilateral accord. Moreover, it includes neither the trade organisation’s rich legislation nor its dispute settlement tools. As a result, global investment rules lack mechanisms to generate a socially and politically responsive body of international civil or common law.

“Still, the new international property rights supported the general investor euphoria of the 1990s. Looking to the new assurances, and with a herd mentality, firms from the industrialised countries leapt to the much-touted golden opportunities in infrastructure across Asia, Latin America, and to a lesser extent Africa. Enthusiasm for foreign investment seized many capital-starved Third World governments as well; it seemed an easy solution not only to a shortage of capital but also to the problems of poorly run state-owned companies. The period was one of great excitement, accompanied by some rather odd behaviour: competitive struggles among Third World countries to attract foreign capital; wildly optimistic profit projections by managers; and unquestioned devotion to private investment by multilateral financial institutions.

“In such conditions, mistakes of judgment were almost inevitable, and so were some eventual disputes. The scale, the frequency, and the geographic spread of the disputes that emerged, however, have been much greater than the inevitable collapse of euphoria would suggest. In a number of developing countries, private investment in infrastructure, once touted as salvation for these capital-short nations, turned into catastrophe.”

Dispute settlement

To explore how well the new guarantees have performed, the book examines several disputes that arose in Indonesia after the Asian currency crises of 1997/98 led to reviews of electric power agreements that the country had negotiated with foreign investors only a few years earlier. The agreements seemed to be protected under the new guarantees, but the assurances proved much less useful to investors than they had expected. Investors that wanted to continue to do business in Indonesia, or even remain in the power business elsewhere in the developing world, hesitated to turn to the new rights, fearing that doing so would lead to bitter relations that would harm their other interests. Only those investors that wanted to bail out anyway found the new rights particularly helpful.

Messrs Wells and Ahmed write: “The disputes exposed the weaknesses in the new property rights for foreign investors. By 2005, the system was faltering. The new rights had proved far too rigid in the face of dramatic economic events, such as the Argentine and the Asian currency crises, and they were too politically charged for governments concerned about sovereignty. As external parties tried to hold Indonesia to strict views of its electric power contracts, one foreign lawyer asked us: ‘The injustice screams out. Is a contract more sacred than the well-being of the fourth largest populace on the planet?’ If external guarantees try to override legitimate national interests, they will fail.

“ … Not only were rights interpreted inflexibly, but outcomes proved unpredictable, access to protections was asymmetric, and the assurances were fraught with the kinds of destructive ‘moral hazards’ that are so often associated with insurance.”

Possible reforms

The problems encountered in the Indonesian and other disputes suggest reforms that would make the guarantees more acceptable to both investors and host countries.

The book concludes: “[Nevertheless] the wisest and most committed foreign investors cannot rely entirely on external guarantees of property rights, whether they are reformed or not. Turning to an improved system of dispute resolution is still likely to strain business relationships. Ultimately, security for most investors lies in how a particular project is perceived by its hosts – by government officials, but also in a democratic Third World, by the press, labour, and NGOs [non-governmental organisations]. Perceptions change. While ITT managers in Indonesia could have reasonably predicted that their technology would provide them with some staying power, they could have also seen that the unrestrained monopoly that they had negotiated would surely someday raise eyebrows, and probably more. And they might have considered that turning down a politically desirable investment would focus attention on their deal. For the power investors in Indonesia, the lack of any unique skills combined with projected returns inconsistent with the allocation of risk should have been enough to warn investors, lenders and insurers of future problems, with or without a currency crisis.

“But a stable international system that takes a balanced approach to property rights in risky countries can add significantly to investors’ security. In fact, when managers make investments where they do not have a dominant and closely held technology or control over important export markets, their profits may ultimately depend on external protections.

“Yet, the current system is, we have argued, not viewed by various parties as fair and reasonable, and as responsive to legitimate national goals. Thus, it is unlikely to survive intact. To quote [an article by lawyer Michael D Goldhaber]: ‘...Emerging nations sometimes find themselves in impossible and unfair situations. It should hardly be surprising that they chafe under their obligations.’ Mr Goldhaber quotes Nigel Blackaby of Freshfields in Paris as saying: ‘This is the fallout of globalisation. Parts of the world feel that they have been failed by the absolute form of capitalism.’”

The book continues: “Absolute forms of capitalism are, in fact, unlikely to survive, regardless of the wishes of its proponents. Although we reiterate our conviction that the flow of productive investments to the developing world can help those nations break out of poverty, our stories from two recent episodes in the history of foreign investment remind us that inflows can sometimes result in bitterness and even greater poverty. If capitalism is to continue to contribute to the development process, it must show a softer face than that presented today by the new international system of property rights.

“One cannot help being reminded of those who credit Roosevelt’s New Deal with saving capitalism. The rules that govern foreign investment – especially what we have referred to as the new international property rights – and the institutions that act as guardians and executors of those rules have to win renewed confidence of both multinational investors and sovereign host nations. Failure to reform the system to redress the imbalance between its attention to the legitimate economic and social concerns of host countries and those of investors will surely mean a retreat by those nations from the system. This will impose costs on both multinational corporations and the poor countries.”

Making Foreign Investment Safe: Property Rights and National Sovereignty is published by Oxford University Press, 2007